As part of President Joe Biden’s efforts to refocus the Federal Reserve Board, the Senate conducted confirmation hearings for several nominees this past week.  While these hearings traditionally raise spirited exchanges about the nominees’ views on monetary policy and bank supervision, a new and more controversial topic involves the extent to which the Federal Reserve should internalize climate risks into its purview.  Before wading into central bank wonkishness, it is important to make clear that climate change represents a serious risk to not only the U.S. economy but to humanity itself.  Nevertheless, we need to be very deliberate in the assessment of the available policy tools, with an eye to where unintended consequences may reside.

With respect to the Fed’s proposed engagement with climate concerns, an understanding of the presumed directionality is required.  Specifically, is the idea to include climate risk as an input to assess financial stability more holistically?  Many have promoted the construction of a kind of augmented climate-related stress test.  Or, are we instead discussing a marked shift in the regulation of financial institutions to force them to serve as a mechanism to promote climate risk mitigation policy. This far more aggressive direction has been promoted by the more progressive wing of the Democratic Party.  In sum, we need to understand whether the argument is climate risk as an input to bank regulation vs. bank regulation as an input to climate risk mitigation.  If the intention really is the latter, we need to better appreciate how this could work. 

The Fed has two (main) functions – monetary policy and financial stability.  On the former, any climate-related monetary policy objective would reflect a significant shift relative to the Fed’s current inflation and labor market mandates.  Leaving aside the fact that Congress would have to formally legislate such an alteration, the Fed is ill-equipped to tackle climate mitigation in the context of its traditional monetary policy toolbox.  To be clear, there is already significant disagreement regarding the appropriateness of the Fed’s current policy stance [we have recently conducted a debate on whether the Fed is behind the curve regarding its inflationary mandate]. Further, while climate risk mitigation is a laudatory objective, there is an auxiliary danger of a politicization of our central bank.  This is not a trivial issue – the Fed’s independence allows it to swiftly respond to economic conditions in a technocratic manner largely free of political influence; a real, or even perceived, erosion of that independence will do nothing but impair its ability to operate when needed.  As a cautionary tale, there is a well-established literature that documents a link between high inflation and the lack of central bank independence.¹

An alternative angle for central bank climate consideration relates to the Fed’s other role in bank supervision (and overall financial stability).  Policies that incorporate climate risk into financial stability calculations seem reasonable. However, , proposals such as adjustment of capital adequacy regulation that would require banks to hold more capital against lending tied to borrowers that are negatively contributing to climate change are more problematic.  Unfortunately, such a modification of capital adequacy risk-weights would simply join a colossal jumble of regulatory complexity that Admati and Hellwig (2013), amongst many others, have shown to be easily gamed with sizable unintended consequences for systemic risk.²  Their work is actually an indictment of the complexity of current capital adequacy regulation; couple that concern surrounding the incentives for regulated bodies to engage in regulatory arbitrage with other important concerns about ESG greenwashingand the challenges of valid climate impact measurement [we will offer a new Kenan Insight on ESG measurement on February 16].  How confident can we be that the disincentives for bank lending would correctly identify borrowers tied to climate risk?

None of these concerns provide justification for Congress’ abdication of its responsibility to attack a very real issue.  However, the avenue for the most effective climate policy is through formal legislation.  Rather than continually trying to outsource its job, legislation is the natural avenue through which we can force the largest contributors to climate risk to internalize the costs of their actions.  As we have argued, a direct carbon tax is likely to be far more effective.  Further, with an appreciation for the fact that the largest carbon producers reside outside the U.S., such tax policy would need to address the cross-border nature of the issue carefully and credibly.  The Fed has virtually no direct role to play in cross-border economic activity.

Climate mitigation is an imperative, but the discussion should revolve around how best to move forward in a manner that more directly targets the intended consequences with an eye to limiting the unintended consequences.  At best, the Federal Reserve will appropriately calculate the financial stability risks of climate change. However, doing more than that could be quite damaging to the institution’s credibility or unintentionally distortionary to the allocation of capital.   The lingering question is instead how do we seriously tackle the challenges of climate change, inequality and beyond when Congress is inactive?  This is not easy stuff, but we need to be very careful in how we go about trying to circumvent those very real limitations.

This article originally appeared on Fortune.com

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